‘There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?”’ – David Foster Wallace, This Is Water, 2005
This article is about the water in which investors are swimming in the shallows of the 21st century: those deep economic, political, environmental and social conditions which are often taken for granted, yet are critical to real world investment outcomes.
This matters because the past thirty years have been kind to investors. Whether you have owned equities, bonds, classic cars or artwork, most people have enjoyed significant real returns. Buy and hold – with some teeth gritting in big bear markets – has worked.
This begs several questions. First, why has the water been so agreeable in recent decades? Second, is this benign environment likely to continue? Third, if not, then what will replace it?
The long-term declines in both inflation and interest rates, starting in the early 1980s, are central to our story, creating as they did a rising tide that has lifted most boats (falling rates and inflation make future cash flows more valuable, lifting asset prices). The emergence of China and the end of the Cold War – both of which added massive new productive capacity global markets – are amongst the most significant drivers of these declines, as was the IT revolution which allowed businesses to exploit the newly open world.
In 1990, US President George H W Bush heralded a ‘new world order’ in which American power would secure the world for capitalism, markets and democracy. Great Power conflict was history, and defence spending – itself inflationary – plummeted: this ‘peace dividend’ freed substantial funds for more productive ends. These political and economic shifts delivered a disinflationary economic boom and unprecedented international peace and stability. Higher global returns to capital followed.
And yet dangerous currents were building. As capital chased higher returns in China and Emerging Markets, local currencies came under pressure to appreciate. Local policymakers resisted (protecting export competitiveness) by keeping their exchange rates artificially low and recycling money back into global markets – especially US Treasuries.
These price-insensitive purchases pushed down developed world bond yields, driving income-hungry investors into securitised products which the shadow-banking system was all too happy to provide. Hello, sub-prime! Lower yields also encouraged more developed world borrowing, much of which flowed back into Emerging Markets, creating a self-feeding dynamic.
Inflation in this world of greatly expanded supply was naturally lower but, rather than leaning into the disinflationary boom, Western central bankers kept monetary policy inappropriately loose, encouraging asset prices and debt to climb.
A series of asset bubbles followed:
Dot Com, the Credit Crunch and now, perhaps, another. With each crisis, rates have been cut to new lows, creating fresh credit and asset bubbles, and encouraging further debt and fragility. When rates hit zero, ‘unconventional measures’ such as Quantitative Easing are employed.
A cascade effect has ensued: interest rate distortions have rippled through the financial ecosystem. Consequently, risk is widely mispriced, and many investors are left holding portfolios which could, in reality, turn out to be far riskier (and more illiquid) than they expect when the tide of ultra-loose monetary stimulus reverses.
Those tailwinds that have made the wealthy, wealthier, have made it harder for people to get on the property ladder. Together with the effects of mass migration, continuing fall-out from the financial crisis, increased wealth inequality and debt, distortions created by the euro and the effects of globalisation, the result is greater political instability across the West.
These pressures are radically reshaping the political landscape, well beyond Brexit: in 2000, European populist parties garnered around 8% of general election votes; by 2018, that figure was 27%*. Populist parties often have radical economic agendas and, for investors, the key danger is that a political backlash will deliver a less stable, predictable and open world of materially higher taxation, inflation and regulation.
Internationally, the stability provided by an American hegemon is eroding as other Great Powers (re-)emerge and challenge the existing rules-based world order. The market impact is already being felt. A slew of recent Sino-American technology deals have been blocked by the US government on national security grounds. Tariffs (and their inflationary effects) are another obvious example. Long-term investors need to pay renewed attention to politics – both foreign and domestic – in a way they have not for a generation.
Simultaneously, many of the disinflationary tailwinds for markets in recent decades look to be turning into headwinds. The supply shocks of China’s re-emergence and the end of the Cold War are fading. The technology revolution continues apace, but many of the low hanging fruit (offshoring; cutting out middle men) have already been plucked. Might even the internet become inflationary with greater regulation? Demographic ageing looks set to encourage spending rather than saving, and political volatility – both national and international – is growing.
For the time being, robust global economic growth helps to disguise some of these challenges - particularly record indebtedness and asset prices – whilst for both the US and the UK, unemployment is at record lows. And yet inflation remains becalmed.
So, what happens next?
1960s America may offer an indication: a period of strong growth, low unemployment and little inflation preceded a period of significantly higher inflation. Interest rates had to rise sharply to contain the inflationary threat. Volatility shot up. Protecting against a world of higher inflation, rates and volatility will be challenging, however, with conventional assets already richly valued on the basis that all three will remain low.
And for today’s investors, there’s an added curveball. Since the mid-1990s, the rolling 5-year correlation between US stocks and bonds has been negative. In other words, each has gone up over the long-run, but helped offset the other in the shorter run: conventional portfolio diversification has worked particularly well. Historically, however, that key relationship is positive – stocks and bonds tend to move directionally together. A reversion to historical norms would reduce the effectiveness of conventional portfolio protections, especially given that both stocks and bonds are near record valuation levels.
1970s Britain offers a warning: neither conventional bonds nor equities protected against the sudden increase of both inflation and interest rates, and investors faced up to 15 years of real terms losses. Investors need to think differently about diversification.
As ever, there is an alternative – the current world of low inflation, interest rates and volatility could trundle on indefinitely. As our Chairman Jonathan Ruffer puts it: “Equity markets look absolutely expensive by historic yardsticks, but they don’t look expensive compared to bonds, and bonds don’t look expensive if long-term interest rates are regarded as settled.”
We think differently. After an era of unprecedented stability, the emergent order looks increasingly disorderly, fragile and ultimately inflationary. This is a world in which record debts, strained government finances and high asset prices meet the retreating tide of central bank stimulus and authority, reduced market liquidity, resurgent Great Power politics and populism. Such a world leaves policymakers with big decisions, big debts and little wriggle room.
Given that austerity has become politically unpalatable, and outright default catastrophic if widely practised, one consequence is likely to be deeper financial repression (where inflation remains above interest rates for a prolonged period of time, and where the gap between the two grows). This provides an escape route for the indebted – notably governments – by eroding the real value of existing debts, but it is also a tax on anyone with savings. One asset that might provide the answer are index-linked bonds, whose prices increase dramatically as the level by which inflation exceeds interest rates expands.
The scale of the debt problem will become more apparent when economic growth stalls and markets land with a (probably deflationary) bump. We cannot know precisely when a crash will come (our guess is soon), but we fear conventional protections may be ineffective so we are positioned to take advantage of some of the distortions wrought by years of ultra-loose monetary policies.
This new, more disorderly, world will bring huge challenges – but also significant opportunities for those that understand the water.
*Ruffer LLP & Deutsche bank, 2018
Issued by Ruffer LLP, 80 Victoria Street, London SW1E 5JL. Ruffer LLP is authorised and regulated by the Financial Conduct Authority. © Ruffer LLP 2018.